Nothing undermines a financial plan more than too much debt.
You may be confident that if you work hard, have a regular income, and try to spend wisely, you don’t need to worry about debt. Yet you live in a world where emergencies, such as a serious illness or the loss of a job, or unforeseen expenses, such as the need for emergency home repairs, can pop up unexpectedly. Since no one is immune from debt, you can help make sure you stay out of financial trouble by creating a well thought-out spending plan and sticking to it.
When you develop a spending plan, or budget, you allocate your income so that it covers your regular expenses, lets you add to your savings or investment account each month, and provides the back-up protection of at least three months worth of living expenses in your emergency fund. While a spending plan doesn’t guarantee you’ll stay out of debt, it can help protect you from unpleasant financial surprises.
Debt that works for you
Of course, not all debt is bad.
Productive debt, like student loans that enable you to go to school, or a mortgage that makes it possible for you to buy a home, can be used as strategic tools to help you reach your goals. While you owe money now, getting a student loan to pay for a graduate degree is likely to increase your chances of a brighter financial future since more education can lead to higher-paying jobs down the road. Similarly, owning a home can often save you money as well as provide a place for building family traditions.
Good debt has some specific characteristics. For instance, both student loans and mortgages offer comparatively low interest rates as well as some tax advantages. Typically, a portion of mortgage interest is tax deductible, which lowers your taxable income. And depending on your income, interest on education loans may be deductible as well. These savings free up money that can be used to bolster your retirement savings or other investment accounts. In addition, you have something to show for good debt that won’t wear out or go out of style before you’ve finished paying for it.
Debt that works against you
On the flip side, there is debt that can leave you mired in red ink, and leave you farther away from your financial goals. Generally, harmful debt, like large credit card balances and unsecured personal loans, carries high interest rates and doesn’t offer tax-deductible interest. Since it costs so much to pay this debt off, the amount you owe can build quickly and begin to drain your financial assets.
How much debt is acceptable?
One rule of thumb you can use to determine if you have a reasonable amount of debt is known as the debt-to-income (DTI) ratio, or the 28/36 rule. According to this rule, you should pay no more than 28% of your pretax income for housing and no more than 36% of that income on housing plus all other debt.
For example, if you have a household income of $100,000, your goal would be to spend no more than $2,333 a month, or $28,000 a year, on your mortgage plus homeowners insurance and real estate taxes. If you rent, the same 28% guideline applies. In addition, you should plan to keep your total debt at no more than $3,000 a month, or $36,000 a year.
In general, if you are spending 40% or more of your pretax income to pay down your debt that should be a red flag that you may be in, or getting in, over your head.
There are a number of other ways you can spot a looming debt problem. Early warning signs include not being able to pay your credit card balances in full, maxing out your lines of credit, regularly owing late-payment fees, and repeatedly applying for additional credit. Another is dipping into your emergency fund to pay down debt, leaving you unprotected should an unexpected financial crisis occur.
If any of these situations sounds familiar, you can make your way to back to financial fitness by taking appropriate steps to rein in your debt. However, ignoring debt means you could face more serious consequences.
For instance, if you’re continually unable to make payments when they’re due, you could be subject to late fees and higher interest rates on your outstanding debt. You may also be assigned a bad credit rating or denied the ability to borrow again. Worse still, you could be sued or forced into bankruptcy.
Managing your debt
One of the first steps to managing your debt is figuring out how much it’s costing you to pay off your outstanding balances. The first step is to compile a list of any car loans, student loans, mortgages, or other debts you owe, as well as any outstanding balances on your credit cards. Then, add up the interest and finance charges you’re paying by checking those amounts on your payment slips and credit card statements.
Next, since your high-interest and biggest-balance debt will impact your spending the most, you might try to pay it off first. If it’s a credit card balance you’re repaying, it’s typically a good idea to avoid making any additional charges on the card until you’ve paid off what you owe.
You may also want to consider talking to your creditors about changing the terms of your arrangement, reducing your monthly payment, or both. These measures will extend the payback period and probably cost you more in finance charges over the long term, but it may keep you from drowning in debt.
Another option is to consolidate your loans. Loan consolidators are private businesses that lend you money to pay off all your debts. You then owe only one creditor: them. The good news is that you write only one check a month, you can repay over a long term, and you can make low monthly payments. The bad news is that the interest they charge may end up being higher than what you are already paying. In addition, it may take you longer to repay what you owe, and you may be hit with stiff fees for paying off the loan ahead of schedule.
Before you decide to work with a consolidator, it’s essential to research the company’s record for consumer complaints or legal problems. That’s not hard to do online. You should also meet with a qualified credit counselor affiliated with a not-for-profit organization such as the National Foundation for Credit Counseling (www.nfcc.org) or the Financial Counseling Association of America (www.fcaa.org).
This information is provided with the understanding that the authors and publishers are not engaged in rendering financial, accounting or legal advice, and they assume no legal responsibility for the completeness or accuracy of the contents. Some charts and graphs have been edited for illustrative purposes. The text is based on information available at time of publication. Readers should consult a financial professional about their own situation before acting on any information.